Tuesday, May 04, 2004

Economics of the EU Enlargement

The following article, which looks with some criticism at the economic performance of the European Union and even more scepticism at the process of enlargement, is reprinted from the Washington Times with the express permission of the author, Dr Marian L. Tupy, assistant director of the Project on Global Economic Liberty at the Cato Institute.

Fifteen years ago, Central and Eastern Europe abandoned communism. Freed from Soviet shackles, the region set its sight on joining the European Union. At that time, the EU's economic vitality and political harmony seemed almost too good to be true. Those days, however, are long gone and many people in post-communist Europe wonder if joining the EU was a good decision. What went wrong?

To start, the EU is no longer a poster child for economic development. In fact, it is clear now there is no correlation between the membership of the EU and economic growth. Between 1998 and 2003, for example, average GDP growth in Slovakia was 3.23 percent yearly. Yet Slovakia was not in the EU. The German economy, on the other hand, grew at an average of 11/4 percent during the same period.

In the past, Europe benefited from considerable economic liberalization brought about by the Treaty of Rome and the Single European Act. In those days, European integration consisted of breaking down barriers to movement of goods, services, capital and labor.

Over the past decade, however, that approach was superseded by increasing centralization of economic decision-making in Brussels and top-down harmonization of rules of production, delivery and sale. Those pan-European regulations stifle competition. In effect, harmonization increases the costs of production throughout the EU to levels favored by high-cost producers in Western Europe. That eliminates competition from low-cost producers, such as those in Central and Eastern Europe.

Again, Germany and Slovakia may serve as examples. Safety standards of German food production are high, but wealthy German consumers can afford to pay higher food prices and that keeps German food producers in business. In Slovakia, on the other hand, 3,000 people in the dairy industry lost their jobs because their employers lacked the capital necessary to meet the EU standards of production.

The same applies to environmental rules. Though everyone prefers a clean environment, high environmental standards in the EU can only be met by increasing the tax burden of the already impoverished citizens of the accession countries. Some of the cost associated with the Central and East European accession to the EU was supposed to be offset by financial aid from the West -- itself a dubious development strategy. In 2004, the new members are set to net a total of 1.8 billion euros. However, the cost of environmental rules alone will come to 10 billion euros over the same period.

Not surprisingly, the new members feel cheated. That feeling is exacerbated by the fact that, despite assurances to the contrary, their membership in the EU will be decisively second class. In contradiction of the EU rules, workers from new members will be prohibited from seeking employment in the west. Moreover, farmers in the accession countries will be subjected to unfair competition from Western farmers. Under the dysfunctional Common Agricultural Policy, farmers in the West will receive subsidies 4 times larger than those of their counterparts in the East.

The EU subsidies encourage overproduction. Therefore, a harmful system of production quotas has been put in place, leading to continued bickering among the member states. Slovakia, to give an example, asked to produce 1.2 billion liters of milk per year, but the EU agreed to only 950 million liters per year. Slovakia wished to raise 400,000 sheep, but the EU agreed to only 218,000 sheep. Farmers in the region can be excused for complaining that this type of economic planning is eerily reminiscent of Soviet-era production quotas.

As a result of increasing harmonization, the Central and Eastern European countries resorted to tax cuts to improve their business environments. Thus, Estonia has a zero percent corporate tax on reinvested or retained profits. Lithuania and Slovakia have corporate tax rates of 15 and 19 percent respectively. Latvia and Hungary, which have respective corporate tax rates of 19 and 18 percent, will lower them to 15 and 16 percent in 2004. Poland plans a tax reduction from 27 to 19 percent.

Some current EU members see tax cutting as a threat and German Chancellor Gerhard Schroeder is trying to intimidate the new members into reversing their business-friendly economic policies. If he succeeds, the consequences for the new members could be devastating.

The conflict at the heart of EU enlargement, therefore, could not be starker. On the one hand, many current EU members are determined to pursue a policy of job protection and high taxation, necessitated by burgeoning welfare costs.

On the other hand, the new EU members, whose citizens continue living in poverty, need to generate rapid economic growth and catch up with the West.

As businesses throughout the enlarged EU choose where to invest, the conflict between the West and the East will be exacerbated. It is not at all clear the EU is strong enough to withstand the recriminations and animosities the enlargement will cause in the future.